Price Gouging

Despair. RT @GovChristie: The State Division of Consumer Affairs will look closely at any and all complaints about alleged price gouging.

When there’s a natural disaster some people, like Gov. Christie, start complaining in knee-jerk fashion about price gouging. And then some other people, with their knees jerking in exactly the same fashion, start complaining about people who complain about price gouging. The latter sets of knees usually belong to economists.

Suppose that an unexpected shock has occurred which has two effects. First, it increases demand for, say bottled water. Second, it cuts off supply lines so that in the short-run the quantity of bottled water in the relevant location is fixed at Q. A basic principle of economics is that if you wish to maximize total surplus then you should allow the price to adjust to its market-clearing level. This ensures that those Q consumers with the highest value for water get it. The total surplus will then be the sum of all their values.

The price plays two roles in this process, one crucial to the result, one just incidental and not necessarily intended. First, it separates out the high-value consumers from the low-value consumers. That’s the crucial role. Unavoidably it also plays a second role of taking some of that total surplus away from the consumers and giving it to producers. If you are maximizing total surplus you are completely indifferent to that second effect.

But what if you don’t want to maximize total surplus but just want to maximize consumers’ surplus? Your goal is that the Q bottles of water you’ve got should generate the greatest possible benefit for those who will consume them. I would bet that most people who understand the previous paragraph also assume that it applies equally well to the problem of maximizing consumer’s surplus. How else would you maximize it but to ensure that those with the highest value get the water?

But in fact it is quite typical for the consumer surplus maximizing solution to be a rationing system with a price below market clearing. I devoted a series of posts to this point last year. The basic idea is that the efficiency gains you get from separating the high-values from the low-values can be more than offset by the high prices necessary to achieve that and the corresponding loss of consumer surplus.

Why would we only care about consumers’ surplus and not also the surplus that goes to producers? We normally we care about producer’s surplus because that’s what gives producers an incentive to produce in the first place. But remember that a natural disaster has occurred. It wasn’t expected. Production already happened. Whatever we decide to do when that unexpected event occurs will have no effect on production decisions. We get a freebie chance to maximize consumer’s surplus without negative incentive effects on producers. And just at the time when we really care about the surplus of bottled water consumers!

Of course there are other good reasons to be skeptical of rationing in practice. It might not be enforceable, it might lead to inefficient rent-seeking, etc. But these objections mean that the debate should be about rationing in practice. The theoretical argument against it is weaker than many people think.

23 comments

While it has no impact on production, higher prices during crises still has a direct impact on supply through imports, no? Higher prices will induce people to shift needed resources from oversupplied to undersupplied areas, and all but eliminate the potential for hoarding. I think when you consider total supply and demand inside and outside of the affected area, the consumer maximizing policy would be flexible pricing. The producer surplus is just a bonus.

We know that emergency conditions occur from time to time, even if we don’t know the exact timing. Furthermore, the possibility that this particular emergency would occur could be seen coming for at least a few days if not weeks beforehand. Therefore, private actors might have an incentive to stockpile inventories in order to make a profit charging higher prices when and if the emergency occurs. Anti-gouging laws take away this incentive, potentially making everyone worse off.

Would/could private actors actually fill this role of stockpiling for emergencies? Ironically, one thing that might prevent them is that the government cannot credibly commit to allow them to gouge when the emergency comes!

I think there might be a similar problem with things like the Strategic Petroleum Reserve. In other words, it might make sense for the government to stockpile petroleum against shocks even though private actors could theoretically do the stockpiling more efficiently. The private parties would always be too afraid that when it was time to take the profits they’d face some sort of windfall profits tax.

Supply is not fixed even in a disaster. Right now there are thousands of stores in NJ on the fence about whether to reopen. The fear of “price gouging” fines is certainly keeping some of them closed, to the detriment of consumers.

These “unexpected” bad events – are they actually wholly unexpected in the sense that even survivalist and “prepper” folks would remark, “I never imagined anything like that coming, nor considered stockpiling or producing anything that would be useful when it did”? Or are they merely unexpected in the sense that calling them “unexpected” after the fact allows one to construct a shaky moral case for taking surplus (and moral authority) away from the people who did expect and prepare for them? That latter definition seems to be popular.

I’m guessing that it’s the latter here, too. Since it’s obviously too late for a blogger-led campaign to affect economic policies regarding Hurricane Sandy, your recommendations could only be intended to apply to future natural disasters, almost as if you were *expecting* more such events…

Normal supply lines, you mean. But entrepreneurs who see a way to get bottled water into Manhattan during an emergency–through normally less efficient means, small boats, mini-vans–will have higher per unit costs than those of well-developed suppliers.

What about, everybody receives the same utility from water, but our utility function is concave. In this case maximizing CS means giving everyone the same amount of water, regardless of the money they have. Hence, the competitive market will not work, i.e. wealthy people will get more water than poor people, not because they value water more, but because they can afford it. However, the Rationing mechanism will achieve first best.
All of this assuming that the supply is fix or rigid.

Yes, incentives are one reason for caring about producers, but not the only reason. Producers also are people, just like consumers, and we’d like to see their utility increased, ceteris paribus. Thus, even if production decisions don’t change, I don’t follow your argument that we should put zero weight on producer surplus.

Why is a dollar in a consumer’s pocket valuable but a dollar in a producer’s pocket worthless? Presumably, the producer will eventually spend the dollar (if you let him have it) and become a happier consumer.

The argument (for allowing price to ration goods even in natural disasters) holds income distribution constant, but this is probably the real issue for the policy maker concerned about ‘price gouging,’ isn’t it? Policy makers conveniently come down on one side or the other of the efficiency/equity frontier, depending on the circumstances. And, much to our chagrin, they usually sound like Keynes’ practical men when they try to justify their position!

Jeff, supply lines were not cut. I live in central jersey. It would be very easy for me stock up on gas, generators, batteries etc. and drive up to north jersey and nyc to sell them. Of course, I’ll be arrested if I do that.

And I’m not sure if it is demonstrable that the gains from increased consumer surplus (are producers not people as well?) outweighs the gains from separating the high-values from the low-values.

And when you consider the opportunity cost of waiting in line for 4 hours for gas should properly be included into total cost of acquiring gasoline, can we really say there are gains in consumer surplus at all?

[…] gouging is again making the rounds of the Econ blogosphere. Michael Giberson summarises things. Jeff Ely has concocted a scenario in which he thinks gouging worsens outcomes. I’m going to disagree with specific reference to […]

[…] gouging is again making the rounds of the Econ blogosphere. Michael Giberson summarises things. Jeff Ely has concocted a scenario in which he thinks gouging worsens outcomes. I’m going to disagree with specific reference to […]

[…] gouging is again making the rounds of the Econ blogosphere. Michael Giberson summarises things. Jeff Ely has concocted a scenario in which he thinks gouging worsens outcomes. I’m going to disagree with specific reference to […]

[…] more sophisticated critique of those who oppose anti-price gouging laws comes from the economist Jeff Ely. He argues that when natural disasters have happened, supply by-and-large cannot respond, so […]